Moral Hazard and the Crisis, Revisited (Part I)

I want to revisit the subject of moral hazard and the financial crisis, which I posted about yesterday, because I think the argument I made has been misunderstood in an important way, and because I think it’s useful to look a little more deeply at what exactly people mean when they use the phrase “moral hazard.”

The argument I made yesterday, and in the magazine last year, was that the importance of moral hazard in sparking the financial crisis by encouraging reckless behavior on the part of bank executives has been overrated. If we’re looking for explanations for why things went so badly wrong, I think we’d be better off looking elsewhere. (My list would include, among other things, perversely-designed compensation schemes, a Wall Street bias toward short-term gain versus long-term cost, investor herding, institutional groupthink, and the like.)

In saying that moral hazard—meaning here the problem created by the conviction that some banks are too big to fail—wasn’t a major cause of the past financial crisis, though, I wasn’t saying, as Megan McArdle suggests, that there is no moral hazard problem in the financing of big banks today. On the contrary, I think that a serious moral-hazard issue now exists because of the fact that the country’s biggest banks currently benefit from an implicit guarantee that they will not be allowed to fail. But the fact that moral hazard is a serious problem now doesn’t mean that it was a key element in the inflation of the housing bubble. And paradoxically, of course, one reason people are so sure now that the government won’t let the big banks fail is precisely because the government did allow a big bank—Lehman Brothers—to fail, and reaped the whirlwind as a result. Because the government was so concerned with not exacerbating the problem of moral hazard—thus Hank Paulson’s famous quote about not wanting to be called “Mr. Bailout”—it’s actually made moral hazard worse.

James Surowiecki is the author of “The Wisdom of Crowds” and writes about economics, business, and finance for the magazine.